Rethinking Risk in Offshore Outsourcing Deals

During the past year, finance chiefs have been wearing bifocals, peering into the crevices of their companies' various department budgets for cost savings.

Offshore service providers have seen the shift first-hand since the lengths and volumes of new outsourcing contracts began shrinking — or stopping altogether — last fall. While their client companies still want to take advantage of cheaper labor costs offshore, they have pulled back on starting new projects and have been making more demands of their suppliers. In turn, to get business, service providers have been more willing to negotiate.

One topic the service providers are bringing to the table: currency-fluctuation risk. That's an issue that was largely ignored when the outsourcing industry for technology jobs took off about a decade ago. But as companies have started to scrutinize contract terms and as the dollar strengthened earlier this year, it brought the topic to the forefront. For many buyers and sellers of offshore services, it is now a top-of-mind issue, say professionals who advise both sides on outsourcing contracts.

Currency risk "has become much more of a focus in the outsourcing industry than it has been in the past because of the fluctuation and volatility of the dollar," Mark Mayo, partner and president of TPI Global Resources Management, told CFO.com.

The shaky global economy brought substantial volatility to the currency markets last year. That was particularly true for offshoring deals — many of which are done in India. The Indian rupee weakened against the U.S. dollar, losing 23.3% of its value in 2008, according to outsourcing advisory firm Pace Harmon. And the rupee has continued to be weak this year: while one dollar would have bought a little over 45 rupees at the end of 2003, today it would buy almost 50 rupees.

Most U.S. companies in the middle of offshore contracts haven't seen their bills change, since many of them pay for the services in U.S. dollars. But vendors have been earning more off those same dollars since the weaker rupee decreased their cost of services. "While there's less risk in paying in dollars — in the sense that you know what you pay in dollars today will be the same that you'll pay tomorrow — you are leaving a lot of money on the table," David Rutchik, a Pace Harmon partner, told CFO.com.

As a result, currency-fluctuation risk has become a "big discussion point" during offshore deal negotiations, according to Barbara Murphy Melby, a partner in Morgan Lewis's global outsourcing, technology, and commercial transactions practice. But while the risk of swings in foreign exchange rates has become more of a hot topic, how the parties deal with it varies, depending on the size and experience of the company outsourcing and the whims of their vendor.

Melby told CFO.com that smaller companies tend not to have the in-house staff necessary to properly hedge the risk themselves, and they expect vendors to shoulder the risk instead. However, that demand comes with a consequence. "I don't think pushing 100% risk onto a vendor is cost-free," she says. "There is some type of premium or cost attached to that, because the vendor will be taking on the risk. Having said that, some vendors will take on the risk to win the deal."

A less-common option that has gained some traction this year is the concept of adding a provision in a new contract that gives outsourcing buyers a chance to renegotiate the payment terms or even terminate the deal if the exchange rate turns against them. And vendors are willing to consider this idea, Melby says. "They are acknowledging that one primary reason for entering into an outsourcing deal is cost savings. If those savings are so eroded [because of a change in currency rates], the deal makes no sense."

In fact, some vendors are themselves bringing up the option of putting a clause into contracts to account for changes in the exchange rates. After all, they also could get burned on potential profits by fluctuations, particularly those that do business in the pound or euro, which are stronger than the dollar. Don Jones, international tax partner of BDO Seidman's technology practice, says three of his service-provider clients have talked about making that type of change to their agreements in the past six months.

Service providers working under weakening currencies have wiggle room to offer discounts, since they've been able to keep their margins intact, Rutchik notes. Moreover, vendors are also in the midst of a buyer's market and need to make offers to get business. Total contract values for agreements worth at least $25 million were down 22% during the first six months of 2009 compared with the same period last year, according to outsourcing advisory firm TPI. And the number of signed contracts was down 11%, with only 135 awarded during last quarter.

In addition to the slowdown, the offshore market is still working to reassure customers following the financial scandal at Satyam Computer in India earlier this year. "Satyam made everybody more aggressive," says Rutchik. "We're encouraging clients to revisit their existing deals and look for opportunities in new deals. Buyers have much more of the upper hand than they had over the past few years."

The buyers renegotiating these days tend to be large companies that are in their second or third phase of using offshore services, according to Helen Huntley, vice president of research in the global sourcing area at Gartner. Offshoring first-timers are so "enamored" by labor arbitrage that they are less comfortable or savvy with their negotiating power, she adds.

Rutchik suggests considering the following pay structures when working through the terms of an offshore deal — and recommends treasury departments provide input on the terms if they are not already doing so. In general, he advises companies to pay with their local currency, but says the ultimate decision depends on their risk tolerance, where they do business (will their product be sold under the offshore provider's currency?), and their expertise. Here are the options, from lowest to highest risk to the outsourcing buyer, in Rutchik's view:

1. Pay a set amount in U.S. dollars.The most typical set-up, this gives CFOs a clear, set projection for how much the outsourced project will cost over time, and makes it so they don't have to worry about currency fluctuation. However, companies could lose out on any gains the service provider gets if the dollar strengthens. Rutchik recommends companies make up for this uncertainty by pushing for discounts, since "the offshore provider needs fewer dollars to pay for its local services."

2. Hedge for the risk of currency fluctuation. This is recommended only for companies that have experience and expertise — large companies generally do this as part of their overall hedging strategy.

3. Take a middle-ground approach through banding.The buyers and sellers agree that the outsourcing fees won't change if the exchange rate stays within a certain band, say 5% in either direction. But if it does go beyond that point, both parties share the difference.

4. Factor in past currency movements and recalculate every year.By calculating the average exchange rate for a previous period, such as the past six months, and accounting for those changes when negotiating fees, buyers could have more certainty in their project budget for each year of the contract. However, there's risk if the previous period being recorded was particularly volatile or if the offshore provider's currency appreciated during the previous period.

5. Make payments in U.S. dollars based on the fluctuations of the outsourcer's local currency.In this way, companies are paying more directly for the outsourcer's cost of doing business and can realize the savings if the services being provided take place in a region whose currency has historically fallen in value. If the devaluation continues, though, outsourcers may cut back on their resources and services to make up for their losses and their clients' gains.